401k Withdrawal Rules for Home Purchase 2021 2021
CASAPLORERTrusted & TransparentThe minimum down payment required for a loan is the largest obstacle to buying a home. Even if you know your income is more than enough to support your mortgage payments, you may not have enough saved for the large 20% down payment that some mortgages require. Many people look at their assets and think taking money out of their 401(k) is a quick and easy method of meeting this requirement. However, there are many conditions and drawbacks to consider before withdrawing from your 401(k).
What is a 401(k)?
A 401(k) is a company-sponsored retirement account. It is called your 401(k) because the foundation for this savings plan is the 401K provision in the IRS code. Employees contribute part of their salaries, and some employers can match it. Instead of getting a constant interest rate, you must invest your 401(k) savings into securities (stocks, bonds, ETFs, REITs, etc.) to earn a return. 401(k) accounts have three main benefits to encourage people to make contributions.
- Any income contributed to a 401(k) is not taxed
- Any returns generated on investments from your 401(k) are not taxed
- Employers may match contributions either partially or fully
However, these benefits do not exist without caveats. The government does not want your 401(k) to be a better tax-free savings account (TFSA). Instead, the government puts two primary restrictions on early withdrawals to encourage long-term investing for retirement.
Can I use my 401(k) for a first time home purchase?
While the government discourages early withdrawals from your 401k, you can access the money in it using two different methods. You may either take out a 401(k) loan or make a 401(k) “hardship” withdrawal.
1. 401(k) Loans
A 401(k) loan is a “self-issued” loan, which means you borrow from your own 401(k) and repayments return to your account. Typically, the maximum loan term is five years, but this can be extended if the loan is used to buy a principal residence. With a 401(k) loan, you avoid the 10% early withdrawal penalty, and the amount will not be subject to income tax. The government does this because you have to repay yourself, so you are still saving for your retirement.
Advantages
- Avoid early withdrawal penalties
- The money returns to your account, and you continue to save for retirement
- 401(k) loan debt is not factored into your Debt-To-Income (DTI) ratio
- Failure to meet payments will not affect your credit score
Disadvantages
- Must be paid back with interest (typically the Prime Rate + 2-3%)
- No additional contributions during the loan term (interest payments are not contributions and are unmatched by your employer)
- Failure to repay the loan turns it into a 401(k) withdrawal
- Not offered by many 401(k) providers
2. 401(k) "Hardship" Withdrawal
If your employer does not offer 401(k) loans, they may still offer a 401(k) withdrawal.
For people under the age of 59½, a “hardship” withdrawal or early withdrawal from your 401(k) is allowed under special circumstances, which are on the IRS Hardship Distributions page. Using your 410(k) for a down payment on a principal residence is classified as a hardship withdrawal. By opting to use a hardship withdrawal, you will have to pay the 10% early withdrawal penalty, and this amount will be considered taxable income. Exceptions are on the official IRS page. Generally, these exceptions are difficult to qualify for, so a 401(k) loan is usually better.
Advantages
- You do not have to repay the amount
- You can continue to make contributions
- More widely available than 401(k) loans
Disadvantages
- You will probably incur an early withdrawal penalty
- The amount withdrawn will be taxed
How much can you withdraw from your 401k for a home purchase?
The maximum withdrawal amount varies depending on the method you use. Start with a 401(k) loan because it is the financially responsible choice. You can cover any remaining fees with a 401(k) withdrawal because of the 401(k)’s stricter loan requirements.
Due to a recent congress ruling, if your employer allows it, you are allowed to withdraw both your employer’s 401(k) contributions and any investment earnings as well as your contributions.
Should you use your 401k for a home purchase
Your 401(k) should be the last place you look for down payment assistance. The government encourages you to keep money in this account to save for your retirement. Even with a 401(k) loan, you cannot make contributions for five years. The money in a 401(k) appreciates through investment returns. If you withdrew $20,000 out of your account today, with an annualized return of just 5%, you would be $86,000 poorer 30 years from now. There are also many other downsides associated with using your 401(k) for a home purchase:
- Early withdrawal penalties and increased taxable income
- Your 401(k) provider may charge you additional fees for early withdrawals or loans
- Since you cannot make contributions, you will lose out on any company matching programs that could double your contributions
- If you lose your job or quit, you will have to repay a 401(k) loan in full
Alternatives to Using a 401(k) for a Home Purchase
You may not need a 401(k) loan or withdrawal to begin with. If your mortgage lender allows it, you can make a down payment of less than 20%. While a 20% down payment is standard, you only have to pay your minimum down payment. If your down payment is less than 20%, you get charged monthly Private Mortage Insurance premiums until you own 20% of your home’s equity. Generally, paying for these premiums is better than taking money from your 401(k).
Before using your retirement funds to pay for a down payment, consider any alternatives you have available:
1. Savings and Investment Accounts (CDs, Stocks, Bonds, etc.)
Check any liquid assets you have available. Before getting a mortgage, make sure your income supports the monthly mortgage payments and that you have savings for emergencies. Check how much house can i afford calculator to help you determine your affordability.
2. Federal and State Government First-Time Home Buyer Programs
The federal government has many first-time home buyer programs with lower minimum down payments and down payment assistance programs. You should also check with your state’s local housing authority because each state has unique first-time home buyer programs.
3. Family and Friends
Getting a family gift can help you secure a down payment without having to take on unnecessary debt or compromise your retirement funds. This family gift cannot be a loan.
4. Personal Loans
Banks and other lenders will give you a personal loan if your creditworthiness is high. However, this will add to your Debt-to-Income (DTI) ratio, which may affect your mortgage conditions and eligibility.
5. IRA
If you have an IRA, there are special provisions for first-time home buyers. If you have not owned a primary residence in the past two years, you can withdraw up to $10,000 without incurring the 10% early withdrawal penalty (additional amounts have the 10% penalty). This amount will still be considered taxable income.
6. 401(k) Loan or 401(k) Withdrawal
Only after considering all the above options should you take money out from your 401(k). Your 401(k) should be your last resort because of both the penalties and lost retirement funds.